Equity made easy: Diversify your portfolio for minimising risks and maximising returns

Don’t put all your eggs in one basket is an often-used phrase, and it is aptly used in finance. Investors often tend to go overweight on a particular asset class and when that asset class goes through a rough patch, the overall portfolio suffers. What investors often tend to forget is that there is absolutely no way any individual can forecast what is the exact outlook for a certain investment class, say debt, equity, gold etc. This is because there are several macro and micro factors at play which may or may not impact an investment positively or negatively.

For the sake of hypothesis, let’s consider equity. There are several drivers (local and global) which are likely to affect the everyday trades in equity market and most of them are beyond the control of any one individual. Just because of this factor, shunning away equities is not the answer. Instead one should learn to balance out the risk and rewards offered by equities. And this is where diversification comes in. In its truest form, diversification refers to spreading one’s investments over a variety of assets thereby reducing one’s exposure to one particular asset class. This ensures that the risks associated with a particular asset class will not buoy portfolio, during rough times, thereby aiding long-term wealth creation.

Data suggests that all asset classes such as equity, fixed income, gold, crude, real estate etc. have their respective cycles and as such, different asset class outperforms the others in different periods. Case in point: Bloomberg data shows that each calendar year during 2011-2015 had a different asset class outperforming other assets.

Payoffs among Different Asset Classes

Different asset classes tend to have different returns and risks associated with them. While an aggressive investor may prefer to invest more in equities, a conservative/ risk averse category of investor will formulate an investment strategy to focus more on conservation of capital and hence, the portfolio will hover around relatively safer options such as fixed deposits, bonds etc.

Bloomberg

As evident in the above table, even while equities outperformed other asset classes in two out of five years, the returns were negative in other two years. This is reason why investment in equities is considered risky and volatile, but at the same time it comes with ample liquidity. Similarly, fixed income securities tend to give lower returns, when compared with equity over long term, but is generally considered safe as it tends to conserve the principal amount invested.

Diversification within Asset Class

Even when invested in a particular asset class, one must be reasonably diversified to avoid concentration risk into a particular kind of investment. Such risks can be classified as Company-specific risks, industry-specific risks, sector-specific risks, systemic risks, etc.

Company risks can be associated with a particular company and as a prudent investing strategy; one must not make all his/her investments in a single company. Same is the case with sectors. As such, the failure of that particular company wipes out the entire investment. On the other hand, if one invests in a basket of companies, the loss in one company gets compensated with the returns in other companies. Similar is the case with industry and sector specific concentration risks. Different sectors like aviation, FMCG, banks etc. provide different opportunities at varying points in time and at the same time, face different threats. Accordingly, one must diversify across sectors to minimize risks.

One must also diversify across company sizes since different sized companies (large, mid, small cap) react differently to different external conditions, perhaps due to their wide capital base to capitalize on existing market opportunities and absorb external shocks. As such, it is always recommended to invest over a mix of large cap, mid cap and small cap companies to prevent excessive volatility.

Ideal Portfolio Allocation

As a thumb rule, for an ideal asset allocation strategy, it is desirable that one must invest a percentage equal to one’s age into the non-equity asset class. For example, a 30-year old investor portfolio should comprise of 70% equity and 30% non-equity investments. Further, investment in gold should not exceed 10% of the total portfolio. Yet, such a thumb rule may or may not work for everyone considering the varying risk profile and investment need.

(The writer is a Class 11 student at Dhirubhai Ambani International School. This is the first in the Smart Investing Series.)